The Slow Revolution in German Banking

If the Germans cannot restructure their banks, maybe the locusts can help?

Europe’s most prosperous economy has long proved wrong the conventional wisdom of the past 20 years about what modern finance should be. Germany has no flashy financiers, hedge funds are frowned upon, and bankers’ pay and bonuses remain contained. The expression “golden boys” never seemed to be properly translated into German.

And the banking industry has for a long time looked unfashionable, at least by the standards of global finance. Based on prudent savings and safe deposits, it operates under the rigorous tutelage of public authorities when banks are not owned outright by the state or the country’s powerful regions.

This may be about to change. As the German banking sector enters an era in which it will need to change and restructure, some of the funds likened to “locusts” by a German politician 14 years ago seem to have found fertile ground to deploy their talents.

Private equity funds are showing increasing interest in a sector that looks ripe for a major restructuring. This began with the privatization of the “Landesbanken”, the regional institutions that have long powered the banking system.

In the latest example, Apollo and Cerberus, two U.S.-based investment funds, are bidding for a stake in one of the country’s largest regional banks, Hanover-based NordLB. The German bank needs to raise €3bn-plus of capital that its current shareholders cannot, or will not, provide.

The discussions have been dragging on for weeks. NordLB, bleeding from loans to the shipping industry that have turned sour, is a showcase of the German banking industry’s long-standing problems. Its business model is shaky, its shareholders confused and its politics messy.

In a shareholding structure often seen at German Landesbanken, the states of Lower Saxony and Saxony-Anhalt hold a majority stake in NordLB, while the regions’ savings banks together own 35%. Apollo and Cerberus seem to be the only parties interested in a stake in NordLB, after a mooted plan to merge it with another Landesbank, Frankfurt-based Helaba, hit the skids earlier this year.

It would not be a maiden investment for either fund, both of which have built up extensive stakes in German regional banks and appear to be aiming to play a major role in the sector’s restructure.

Some see this as long overdue. After being bailed out by public money a decade ago when the financial crisis revealed their shaky foundations, Germany’s public banks, which account for 26% of the country’s banking assets, are still looking for a viable business model. Their historic, explicit public guarantee has been gradually phased out after a 2005 EU demand.

The interconnection of business and politics at the regional and local levels, in the context of Germany’s booming economy in the decade before the financial crisis, created an environment where risk was not on bankers’ minds. Banks operating in the domestic market had few reasons to worry. And their big brothers the Landesbanken did not know much about the products they were investing in abroad.

“The loss of their historical business model led to an increase of their funding costs and explains why banks such as NordLB took on excessive risks,” said Isabel Schnabel, a professor of economics at the University of Bonn and member of the five-strong German Council of Economic Experts, which advises the government on policy issues.

The need for a serious restructuring shows in the sheer number of banks operating in the country: there were 1,584 banks at the end of 2018, according to European Central Bank data, nearly four times as many as in France, which only counts 409. Germany’s population is only 18% larger than France’s.

The Landesbanken were created to manage payments for their savings banks’ shareholders. In the years preceding the 2008 credit crunch, the size of Germans’ massive savings pushed the Landesbanken to take on wholesale banking activities and turn to foreign markets. Having ventured into risky investments such as American subprime or Irish property, they came crashing down when the financial crisis struck.

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Landesbanken then underwent bailouts essentially funded by regional governments eager to keep “their” banks and the associated jobs. “But the political context has changed,” said Dierk Brandenburg, banking analyst at European ratings agency Scope Ratings, adding: “There is much less appetite today for state-funded bailouts of banks, and the rules have become stricter.”

That’s because the eurozone joint supervisor has clamped down on both capital requirements and state aid rules.

Furthermore, the bad loans that Landesbanken carry on their balance sheets is luring a type of investor that is rare in Germany: distressed debt funds like Apollo.

NordLB, the last of the big regional banks forced into action after a decade of trouble, is a case in point. The funds vying to buy a stake in the bank, notes Brandenburg, are interested in buying its assets, notably the loans to the shipping industry that have plagued many lenders in the north of Germany.

But the funds’ interest goes further, up to outright ownership. Last year Cerberus led a group of investors that acquired HsH, a small Hamburg-based bank. Apollo bought a private bank, Oldenburgische Landesbank, from Allianz and combined it with Bremer Kreditbank, which it had acquired in 2014, under the OLB brand.

“We see Germany as a country where banks have made good progress in cleaning up their balance sheets, we can help accelerate the movement and move on to the next stage of restructuring through mergers,” explained an executive at one of the investment funds active in the sector.

Cerberus has even taken a stake of just under 10% in
Commerzbank,
the country’s second-largest private lender. Many analysts expect that bank to merge with the ailing national industry leader,
Deutsche Bank,
at some point.

In the public sector, privatization offers the opportunity to escape the European Union’s strict rules on publicly owned banks. “Rules on state aid prevent public authorities to rescue or nationalize a public bank outside of market rules. You just can’t go in and pour billions of public money into an ailing bank,” said Michael Teig, an analyst at UniCredit.

This has become all the more urgent since the ECB’s low and now negative interest rates have compressed German banks’ thin margins, Teig said. Mario Draghi, president of the ECB, may well insist that banks have benefited from the economic recovery fostered by his loose monetary policy. But there is no doubt that negative rates are more painful for the public sector banks (savings banks and the hundreds of cooperative banks), which find it hard to pass negative rates on to their customers, even as they have to pay the central bank just to hold their excess deposits there.

Some may see irony in the current state of German banks at a time when the government in Berlin tends to chastise other eurozone countries, demanding a thorough cleaning of European banks’ balance sheets before agreeing to a deeper banking union.

If NordLB does not or cannot raise capital through privatisation, the risk of a failure is not that far down the road, and it might have to enter the eurozone’s resolution regime.

Governments have tried their best up to now to avoid resolution, which spares taxpayers the cost of bank failures but wipes out a bank’s shareholders and junior creditors. And, as a German banker noted, “resolution has to abide by national laws, so there are always loopholes [allowing politicians to avoid such a regime]”.

He added that if faced with a choice between resolution and privatisation by foreign investors, Germany’s national and regional governments might well opt for the latter. And private equity investment has a lot to bring to an industry plagued by high costs and inefficiencies.

Furthermore, with German banks’ cost-income ratios higher than the European average, there is space for the type of cost-cutting efforts that public owners are often loath to implement, and have long been frowned upon under the kind of social capitalism prevalent in Germany.

The move towards a rationalized banking sector remains slow, however. Teig observed that the number of German banks shrinks by 40 to 50 a year, mostly through mergers. This means that at the current pace, it would take 20 to 30 years for Germany to have the same number of banks per inhabitant as France, hardly an under-banked economy.

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